Introduction to Options

• A financial option is a right to buy or sell a financial security.

• The right trades separately from the (underlying) security and usually even on a different exchange.

• The rights are not (usually) issued by the companies who issue the underlying securities.

  • Instead, the rights are created when someone buys one from someone else.
    
  • Open interest is the number that exist at any time.

• A call option is the right to buy an asset at a pre-specified price.

• A put option is the right to sell an asset at a pre-specified price.

• The pre-specified price is called the exercise price or strike price.

• An option is valid for a specified period of time, after which it expires.
  • Most financial options can be exercised at any time the owner wishes, prior to expiration. Such options are called American.
  • There are some options that can only be exercised on the expiration date. They are called European. Both types are traded on both continents.

• If you’ve bought an option, you are “long.”” If you’ve sold an option, you are “short.”
• After a trade occurs, the option clearinghouse steps in the middle and becomes the counterparty to both sides.
  • The long party has an option to buy from or sell to the clearinghouse at the strike.
  • The short party has an obligation to sell to or buy from the clearinghouse at the strike.

• Usually buyers sell to close their position rather than exercising.
• And sellers buy to close their positions rather than being obliged to buy/sell.
• Open interest rises when a contract first begins to trade, then eventually declines as people trade to close their positions.

Open Interest Example

• When a contract is first opened for trading, open interest is zero.
• Suppose Andy buys a contract from Chloe, and Brooke buys a contract from David.
  • Longs = Andy and Brooke
  • Shorts = Chloe and David
  • Open interest = 2

• Suppose Andy then sells a contract to David.
  • Andy: long + short = no position
  • David: short + long = no position
  • Longs = Brooke
  • Shorts = Chloe
  • Open interest = 1

Hedging, speculation, and income

• You pay upfront to acquire an option.
  • The amount you pay is called the option premium.
    
  • It is not part of the contract but instead is determined in the market (like a stock price).
• You buy options to hedge or to speculate. You sell options for income.
• Sellers of options need to have sufficient equity in their accounts (margin). A buyer needs enough cash to pay the premium but no more (like buying a stock).

Moneyness

• Borrowing language from horse racing, we say a call is

  • in the money if the underlying price is above the strike,
  • at the money if the underlying price equals the strike
  • out of the money if the underlying price is below the strike

• The reverse for puts

• Also, “deep in the money” and “deep out of the money”

Value of a call at maturity

• At maturity (the expiration date), the value of a call is

With strike = 50,

Value of a put at maturity

• At maturity, the value of a put is

With strike = 50,